Behavioural Finance

Question 1

Behavioural finance agrees on…

Answer 1

Right prices imply no arbitrage opportunities

(Makes sense, if prices proper then you can’t resell immediately at a higher price!)

Question 2

However it challenges

Answer 2

The fact that just because no free lunch exists doesn’t mean prices are right!

In fact arbitrage opportunities may stay persistently unexploited.

Question 3

So “prices are right” =“no free lunch”
but “no free lunch” ≠ “prices are right”

In fact arbitrage opportunities may stay persistently unexploited.

Why? (Limits to arbitrage) (2)

Answer 3

Cost! E.g transaction fees, cost of information

Irrational investors - do not maximise profits through exploiting these price patterns

Question 4

So when assets are mispriced, how do we correct?

B) And what is the problem with this?

Answer 4

Portfolios (strategies)

b) the problem is portfolios carry risk often high, so risk adverse investors may be unwilling to use, so mispricing continues. (Lack of short selling, causes overpriced stocks)

Question 5

Value function expression, and key characteristic

Answer 5

u(x)

Has a kink at origin and factor λ represents loss aversion

Question 6

Concave or convex for

A) gains
B) losses

Answer 6

Concave for gains (i.e DMR)
Convex for gains (increasing losses)

Question 7

So with this look, what does it look like graphically (pg 6)

Answer 7

S curve

Question 8

What does convex loss mean?

Answer 8

Losses is steeper than the segment for gains.

Means losses hurt more than the gains help

Question 9

Youo have a 50% chance of getting £150 and a 50% chance of losing £100.

What is the reaction

Answer 9

Despite the positive expected value, most people find this lottery unappealing because the psychological cost of losing £100 is greater than the psychological gain of earning £150.

Question 10

If an individual gains £500 and then loses £500, what would traditional wealth-based utility theory predict vs prospect theory

Answer 10

traditional wealth-based utility theory would predict no change in the individual’s happiness after both transactions took place (since overall no change)

Prospect theory: given enough time to reset reference point (i.e process the £500 gain) , then she would feel a fall in utility/happiness!